ECON 323 University of La Verne Money and Banking Questions
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UNIVERSITY OF LA VERNE
Econ 323 Money and Banking
Exam#1 Review
1. A bond with default risk will always have a ________ risk premium and an increase in its default risk
will ________ the risk premium.
a. positive; raise
b. positive; lower
c. negative; raise
d. negative; lower
Answer: A
2. If the possibility of a default increases because corporations begin to suffer losses, then the default
risk on corporate bonds will ________, and the bonds’ returns will become ________ uncertain,
meaning that the expected return on these bonds will decrease, everything else held constant.
a. increase; less
b. increase; more
c. decrease; less
d. decrease; more
Answer: B
3. Other things being equal, a decrease in the default risk of corporate bonds shifts the demand curve for
corporate bonds to the ________ and the demand curve for Treasury bonds to the ________.
a. right; right
b. right; left
c. left; right
d. left; left
Answer: B
4. A decrease in the liquidity of corporate bonds, other things being equal, shifts the demand curve for
corporate bonds to the ________ and the demand curve for Treasury bonds shifts to the ________.
a. right; right
b. right; left
c. left; left
d. left; right
Answer: D
5. When yield curves are downward sloping
a. long-term interest rates are above short-term interest rates.
b. short-term interest rates are above long-term interest rates.
c. short-term interest rates are about the same as long-term interest rates.
d. medium-term interest rates are above both short-term and long-term interest rates.
Answer: B
1
UNIVERSITY OF LA VERNE
Econ 323 Money and Banking
Exam#1 Review
6. According to the expectations theory of the term structure, the interest rate on a long-term bond will
equal the ________ of the short-term interest rates that people expect to occur over the life of the
long-term bond.
a. average
b. sum
c. difference
d. multiple
Answer: A
7. If the expected path of one-year interest rates over the next five years is 4 percent, 5 percent, 7
percent, 8 percent, and 6 percent, then the expectations theory predicts that today’s interest rate on the
five-year bond is
a. 4 percent.
b. 5 percent.
c. 6 percent.
d. 7 percent.
Answer: C
8. According to the segmented markets theory of the term structure
a. the interest rate on long-term bonds will equal an average of short-term interest rates that people
expect to occur over the life of the long-term bonds.
b. buyers of bonds do not prefer bonds of one maturity over another.
c. interest rates on bonds of different maturities do not move together over time.
d. buyers require an additional incentive to hold long-term bonds.
Answer: C
9. An increase in an asset’s expected return relative to that of an alternative asset, holding everything else
constant, ________ the quantity demanded of the asset.
a. increases
b. decreases
c. has no effect on
d. erases
Answer: A
10. An increase in the expected rate of inflation will ________ the expected return on bonds relative to
the that on ________ assets, everything else held constant.
a. reduce; financial
b. reduce; real
c. raise; financial
d. raise; real
Answer: B
2
UNIVERSITY OF LA VERNE
Econ 323 Money and Banking
Exam#1 Review
11. Everything else held constant, if interest rates are expected to fall in the future, the demand for longterm bonds today ________ and the demand curve shifts to the ________.
a. rises; right
b. rises; left
c. falls; right
d. falls; left
Answer: A
12. Holding the expected return on bonds constant, an increase in the expected return on common stocks
would ________ the demand for bonds, shifting the demand curve to the ________.
a. decrease; left
b. decrease; right
c. increase; left
d. increase; right
Answer: A
13. If a $1000 face value coupon bond has a coupon rate of 3.75 percent, then the coupon payment every
year is
a. $37.50.
b. $3.75.
c. $375.00.
d. $13.75
Answer: A
14. A $1000 face value coupon bond with a $60 coupon payment every year has a coupon rate of
a. .6 percent.
b. 5 percent.
c. 6 percent.
d. 10 percent.
Answer: C
15. If a $10,000 face-value discount bond maturing in one year is selling for $5,000, then its yield to
maturity is
a. 5 percent.
b. 10 percent.
c. 50 percent.
d. 100 percent.
Answer: D
16. What is the return on a 5 percent coupon bond that initially sells for $1,000 and sells for $900 next
year?
a. 5 percent
b. 10 percent
c. -5 percent
d. -10 percent
Answer: C
3
UNIVERSITY OF LA VERNE
Econ 323 Money and Banking
Exam#1 Review
17. If you expect the inflation rate to be 12 percent next year and a one-year bond has a yield to maturity
of 7 percent, then the real interest rate on this bond is
a. -5 percent.
b. -2 percent.
c. 2 percent.
d. 12 percent.
Answer: A
18. If an individual moves money from currency to a checking account
a. M1 decreases and M2 stays the same.
b. M1 stays the same and M2 increases.
c. M1 stays the same and M2 stays the same.
d. M1 increases and M2 stays the same.
Answer: C
19. If the money supply is $500 and nominal income is $3,000, the velocity of money is
a. 1/60.
b. 1/6.
c. 6.
d. 60.
Answer: C
20. If nominal GDP (i.e., PY) is $10 trillion, and velocity is 10, the money supply is
a. $1 trillion.
b. $5 trillion.
c. $10 trillion.
d. $100 trillion.
Answer: A
21. Assume that the interest rate on a one-year Argentina bond that is purchased on January 1, 2016 is
2.5%. This one-year bond matures on January 1, 2017. The interest rate on a two-year Argentina bond
purchased on January 1, 2016 is 3.35%. This two-year bond matures on January 1, 2018.
a. Calculate the expected interest rate in 2017.
ie1t+1 = 2i2t – i1t = 2(3.35%) 2.5% = 4.2%
b. If the Brazilian investor now decides to invest in a three-year Argentina bond with a 4.3%
interest rate, then calculate the expected interest rate in 2018.
ie1t+2 = 3i3t – i1t – ie1t+1 = 3(4.3%) 2.5% – 4.2% = 6.2%
22. Assume that the interest rate on a one-year Vietnam bond that is purchased on January 1, 2016 is
2.15%. This one-year bond matures on January 1, 2017. The interest rate on a two-year Vietnam bond
purchased on January 1, 2016 is 3.8%. The expected interest rate on a one-year bond purchased on
January 1, 2016 (and matures on January 1, 2017) is 4.93%.
a. Calculate the term premium on a two-year Vietnam bond.
2(i2t) – i1t – ie1t+1 = i2tTP
i2tTP = .52
4
Money, Banking, and the Financial System
Third Edition
Chapter 4
Determining Interest Rates
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How to Build an Investment Portfolio
The Determinants of Portfolio Choice
Determinants of portfolio choice (asset demand) are:
1. The investors wealth
2. The expected rates of return from different investments
3. The degrees of risk in different investments
4. The liquidity of different investments
5. The costs of acquiring information about different investments
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Expected Rate of Return
Expected return is the return expected on an asset during a future
period.
The expected return on an investment is:
Expected return = [(Probability of event 1 occurring) × (Value of event 1)]
+ [(Probability of event 2 occurring) × (Value of event 2)].
IBM bond
Bond price at the end of
the year
Capital gain or loss
Rate of return for the
year
Possibility 1
$1,016.50
7% gain
8% + 7% = 15%
Possibility 2
$ 921.50
?3% loss
8% ? 3% = 5%
Example: Equal probability of a rate of return of 15% and 5%.
Expected return = (0.50)(15%) + (0.50)(5%) = 10%.
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Risk
Risk is the degree of uncertainty in the return on an asset.
Most investors are risk averse choose the asset with the lower risk
when two assets have the same expected returns resulting in tradeoffs between risk and return.
Risk-loving investors prefer to hold risky assets with the possibility of
maximizing returns.
Risk-neutral investors make decisions on the basis of expected
returns, ignoring risk.
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Liquidity
The greater an assets liquidity, the more desirable the asset is to
investors.
The Cost of Acquiring Information
All else being equal, investors will accept a lower return on an asset
that has lower costs of acquiring information.
Desirable characteristics of a financial asset cause the quantity of the
asset demanded by investors to increase, and vice versa.
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Diversification
Diversification is dividing wealth among many different assets to reduce
risk.
Market (systematic) risk is risk that is common to all assets of a certain
type, e.g., changes in stock returns as a result of the business cycle.
Idiosyncratic (unsystematic) risk is risk that pertains to a particular
asset (or a firm) rather than to the market as a whole.
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Market Interest Rates and the Demand and
Supply for Bonds
A bonds price (P) and its yield to maturity (i) are linked by the equation
showing its coupon payments (C), face value (FV) and maturity in n years:
P=
C
C
C
+
+
+
2
3
(1 + i ) (1 + i ) (1 + i )
+
C
FV
+
.
n
n
(1 + i )
(1 + i )
Because C and FV do not change, once we know P in the bond market, we
have determined the equilibrium i.
The bond market approach (bonds as the good) is useful when considering
how the factors affecting the demand and supply for bonds affect the interest
rate.
The market for loanable funds approach (funds as the good) is useful when
considering how changes in the demand and supply of funds affect the interest
rate.
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A Demand and Supply Graph of the Bond
Market
Figure 4.1 The Market for Bonds
The equilibrium price of bonds is determined in the bond market.
By determining the price of bonds, the bond market also determines the interest rate on
bonds.
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Figure 4.2 Equilibrium in Markets for Bonds
At $960, the quantity of bonds demanded by investors equals the quantity of bonds
supplied by borrowers.
At any price higher or lower than $960, the quantity of bonds demanded is not equal to the
quantity of bonds supplied.
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Factors That Shift the Demand Curve for
Bonds
Five factors cause the demand curve for bonds to shift:
1. Wealth
2. Expected return on bonds
3. Risk
4. Liquidity
5. Information costs
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Wealth
Figure 4.3 Shifts in the Demand Curve for Bonds
An increase in wealth will shift the demand curve for bonds to the right. As a result, both the
equilibrium price of bonds and the equilibrium quantity of bonds increase.
A decrease in wealth will shift the demand curve for bonds to the left. As a result, both the
equilibrium price and the equilibrium quantity of bonds decrease.
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Expected Return on Bonds
If the expected return on bonds rises relative to expected returns on
other assets, investors will increase their demand for bonds.
Risk
A decrease in the riskiness of bonds relative to the riskiness of other
assets increases the willingness of investors to buy bonds.
Liquidity
If the liquidity of bonds increases, investors demand more bonds at any
given price.
Information Costs
As a result of the lower information costs, investors are more willing to
buy bonds.
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Table 4.2 Factors That Shift the Demand Curve for
Bonds (1 of 3)
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Table 4.2 Factors That Shift the Demand Curve for
Bonds (2 of 3)
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Table 4.2 Factors That Shift the Demand Curve for
Bonds (3 of 3)
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Factors That Shift the Supply Curve for Bonds
Important factors for explaining shifts in the supply curve for bonds:
1. Expected pretax profitability of physical capital investment
2. Business taxes
3. Expected inflation
4. Government borrowing
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Expected Pretax Profitability of Physical
Capital Investment
Figure 4.4 Shifts in the Supply Curve for Bonds (1 of 2)
An increase in firms expectations of
the profitability of investment in
physical capital will shift the supply
curve for bonds to the right.
As a result, the equilibrium price of
bonds falls and the equilibrium
quantity of bonds rises.
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Expected Pretax Profitability of Physical
Capital Investments
Figure 4.4 Shifts in the Supply Curve for Bonds (2 of 2)
If firms become pessimistic about
the profits they could earn from
investing in physical capital, the
supply curve for bonds will shift to
the left.
As a result, the equilibrium price
increases and the equilibrium
quantity of bonds decreases.
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Business Taxes
When business taxes are raised, the profits on new investments in
physical capital decline, and firms issue fewer bonds.
Expected Inflation
For any given nominal interest rate, an increase in the expected rate of
inflation reduces the expected real interest rate.
A lower expected real interest rate is attractive for a firm as it will pay less
in real terms to borrow funds.
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Table 4.3 Factors That Shift the Supply Curve for
Bonds (1 of 2)
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Table 4.3 Factors That Shift the Supply Curve for
Bonds (2 of 2)
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The Bond Market Model and Changes in
Interest Rates
Examples of using the bond market model to explain changes in interest
rates:
(1) The movement of interest rates over the business cycle.
(2) The Fisher effect, which is the movement of interest rates in response
to changes in the inflation rate.
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Why Do Interest Rates Fall During
Recessions?
Figure 4.6 Interest Rate Changes in an Economic Downturn
1. An economic downturn reduces household wealth and thus decreases the demand for
bonds.
2. The fall in expected profitability reduces lenders supply of bonds.
3. In the new equilibrium (E2), the bond price rises.
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How Do Changes in Expected Inflation Affect
Interest Rates? The Fisher Effect
The Fisher effect (asserted by Irving Fisher) indicates that the nominal
interest rate changes point-for-point with changes in the expected
inflation rate.
The Fisher effect implies that:
1. Higher inflation rates result in higher nominal interest rates, and vice
versa.
2. Changes in expected inflation can lead to changes in nominal interest
rates before a change in actual inflation occurs.
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Figure 4.7 Expected Inflation and Interest
Rates
1. An increase in expected inflation reduces investors expected real return, thus the
demand curve for bonds shifts to the left.
2. The increase in expected inflation increases firms willingness to issue bonds, thus the
supply curve for bonds shifts to the right.
3. In the new equilibrium (E2), the bond price falls.
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Making the Connection:
Why Are Bond Interest Rates So Low? (2 of 2)
Between 2007 and 2016, the increase in
government deficits in the United States
shifted the supply curve for bonds to the
right.
However, the demand curve for bonds
also shifts to the right, which was even
greater than the shifts in the supply
curve.
The large increase in the demand for
bonds was due to (1) investors flight to
quality by buying government bonds, and
(2) a the quantitative easing monetary
policy (purchases of long-term securities)
by the Fed and other central banks.
As a result, bond prices increased and
interest rates decreased.
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Interest Rates and the Money Market Model
The Demand and Supply for Money
Money market model is a model that shows how the short-term nominal
interest rate is determined by the demand and supply for money.
This model is also called the liquidity preference model.
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Figure 4.8 The Demand for Money
The nominal interest rate is the opportunity cost of holding money.
The money demand curve slopes downward because lower nominal interest rates cause
households and firms to switch from financial assets to money.
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Shifts in the Money Demand Curve
Variables that cause the money demand curve to shift:
1. Real GDP
2. The price level
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Figure 4.9 Shifts in the Money Demand
Curve
An increase in real GDP or an increase in the price level will cause the money curve to shift
to the right.
A decrease in real GDP or a decrease in the price level will cause the money curve to shift
to the left.
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Equilibrium in the Money Market
Figure 4.10 The Effect on the Interest Rate When the Fed
Increases the Money Supply
When the Fed increases the money supply, the money supply curve shifts to the right, and
the equilibrium nominal interest rate falls.
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Table 4.4 Summary of the Money Market
Model
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The Demand and Supply of Loanable Funds
(1 of 2)
Figure 4A.1 The Demand for Bonds and the Supply of
Loanable Funds
In panel (a), the bond demand curve (Bd) shows a negative relationship between the
quantity of bonds demanded by lenders and the price of bonds.
In panel (b), the supply curve for loanable funds (Ls) shows a positive relationship between
the quantity of loanable funds supplied by lenders and the interest rate.
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The Demand and Supply of Loanable Funds
(2 of 2)
Figure 4A.2 The Supply for Bonds and the Supply of
Loanable Funds
In panel (a), the bond supply curve (Bs) shows a positive relationship between the quantity
of bonds supplied by borrowers and the price of bonds.
In panel (b), the demand curve for loanable funds (Ld) shows a negative relationship
between the quantity of loanable funds demanded by borrowers and the interest rate.
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Equilibrium in the Bond Market from the
Loanable Funds Perspective
Figure 4A.3 Equilibrium in the Market for Loanable Funds
At the equilibrium interest rate, the quantity of loanable funds supplied by lenders equals
the quantity of loanable funds demanded by borrowers.
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The International Capital Market and the
Interest Rate
The foreign sector influences the domestic interest rate and the quantity
of funds available in the domestic economy.
The loanable funds approach provides a good framework for analyzing
the interaction between U.S. and foreign bond markets.
In a closed economy, households, firms, and governments do not
borrow or lend internationally.
In an open economy, households, firms, and governments borrow and
lend internationally.
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Small Open Economy (1 of 2)
In a small open economy, the quantity of loanable funds supplied or
demanded is too small to affect the world real interest rate.
Key Features:
The real interest rate in a small open economy is the same as the
interest rate in the international capital market.
If the quantity of loanable funds supplied domestically exceeds the
quantity of funds demanded domestically, the country invests some of
its loanable funds abroad.
If the quantity of loanable funds demanded domestically exceeds the
quantity of funds supplied domestically, the country finances some of
its domestic borrowing needs with funds from abroad.
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Small Open Economy (2 of 2)
Figure 4A.4 Determining the Real Interest Rate in a Small
Open Economy
The domestic real interest rate in a small open economy is the world real interest rate (rw),
which is 3% in this case.
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Large Open Economy
In a large open economy, changes in the demand and supply for
loanable funds are large enough to affect the world real interest rate.
In this case, we cannot assume that the domestic real interest rate is
equal to the world real interest rate.
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Figure 4A.5 Determining the Real Interest
Rate in a Large Open Economy
The world real interest rate adjusts to equalize desired international borrowing and desired
international lending.
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Making the Connection:
Did a Global Saving Glut Cause the U.S. Housing
Boom?
In response to the argument that the Feds low-interest-rate policy in the 2000s fueled the
housing boom, Ben Bernanke argued that a significant increase in the global supply of
savinga global saving glut . . . helps to explain . . . the relatively low level of long-term
interest rates in the world today.
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Money, Banking, and the Financial System
Third Edition
Chapter 2
Money and the Payments
System
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Do We Need Money?
Money is anything that is generally accepted as payment for goods and
services or in the settlement of debts.
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Barter (1 of 2)
In fact, economies can function without money.
Barter is a system of exchange in which individuals trade goods and
services directly for other goods and services.
Barter exchanges prevailed in the early stages of development in our
economy, but they were inefficient.
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Barter (2 of 2)
There are four main sources of inefficiency in a barter economy:
1. A double coincidence of wants increases the transactions costs.
Transactions costs are the costs in time or other resources that
parties incur in the process of agreeing and carrying out an exchange
of goods and services.
2. Each good has many prices.
When there are N items: Number of prices = N(N 1)/2.
3. A lack of standardization exists for goods and services.
4. It is difficult to accumulate wealth.
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The Invention of Money
To improve on barter, people sought to identify a specific product that
most people would accept in an exchange.
Commodity money is a good used as money that also has value
independent of its use as money.
Money allows people to specialize, so they become more productive, and
earn higher incomes.
Specialization occurs when individuals produce the goods or services
for which they have relatively the best ability.
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Making the Connection:
Whats Money? Ask a Taxi Driver in Moscow!
During a visit to Russia in 1989, one of the authors of this book had
difficulties with taxis.
Taxi drivers quoted fares in dollars, marks, and yen, but not rubles.
For taxi drivers, Marlboro cigarettes were the commodity money of
choice.
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The Key Functions of Money (1 of 3)
Money serves four key functions in the economy:
1. It acts as a medium of exchange.
2. It is a unit of account.
3. It is a store of value.
4. It offers a standard of deferred payment.
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The Key Functions of Money (2 of 3)
Medium of Exchange
A medium of exchange is something that is generally accepted as
payment for goods and services.
Unit of Account
A unit of account is a way of measuring value in an economy in terms of
money.
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The Key Functions of Money (3 of 3)
Store of Value
Store of value is the accumulation of wealth by holding dollars or other
assets that can be used to buy goods and services in the future.
Even though other assets offer a greater return as a store of value,
people hold money because it is perfectly liquid.
Standard of Deferred Payment
As a standard of deferred payment, money can facilitate exchange
over time (not only at a point in time).
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Remember That Money, Income, and Wealth
Measure Different Things
Money is part of wealth, which is the sum of the value of a persons
assets minus the value of the persons liabilities.
Only if an asset serves as a medium of exchange can we call it
money.
A persons income is his or her earnings over a period of time.
So, a person typically has considerably less money than income or
wealth.
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What Can Serve as Money?
An asset is suitable to use as a medium of exchange if it is:
Acceptable to most people
Standardized in terms of quality
Durable
Valuable relative to its weight
Divisible
U.S. paper currencyFederal Reserve Notesmeet all these criteria.
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The Mystery of Fiat Money
Fiat money has no value apart from its use as money, e.g., paper
currency.
People accept paper currency as money partly because it is legal tender.
Legal tender is the government designation that currency is accepted for
payment of taxes and people must accept it in payment of debts.
Our societys willingness to use Federal Reserve Notes as money makes
them an acceptable medium of exchange.
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Making the Connection:
Say Goodbye to the Benjamins? (1 of 3)
Total currency in circulation has almost tripled since 2000, reaching
more than $4,300 for every person in late 2016.
As much as two-thirds of U.S. currency is held outside the United
States.
Some countries, including Panama, El Salvador, Ecuador, and
Zimbabwe, use the U.S. dollar as their official currency.
Large-denomination bills are also useful for people engaging in illegal
activities because those bills allow substantial transactions to be
carried out in cash.
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Measuring the Money Supply
Measuring Monetary Aggregates
Monetary aggregates are measures of the quantity of money that are
broader than currency.
M1 is a narrow definition of the money supply: The sum of currency in
circulation, checking account deposits, and holdings of travelers checks.
M2 is a broader definition of the money supply: All the assets that are
included in M1, as well as time deposits with
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